Mumbai, Oct. 16: The Securities and Exchange Board of India (Sebi) today proposed curbs on participatory notes, which account for almost 40 per cent of investments of foreign institutional investors (FIIs) in stock markets.

It wants FIIs to immediately stop issuing fresh notes, through sub-accounts, and wound up current positions over a period of 18 months.

These steps are one of a series of four proposals from the regulator to crack down on investments coming to domestic stock markets through offshore derivative instruments.

FIIs issue these instruments to overseas investors against ownership of underlying shares in an Indian company. A participatory note is the most popular offshore derivative instrument.

The regulator has sought comments by October 20 on the proposals.

Though the proposals are part of a discussion paper, brokers feel they can cause a major knee-jerk reaction in the stock markets tomorrow.

“The stock markets may open 300-400 points lower and can thereafter dip further by over 500 points during intra-day trades,” said a senior analyst with a domestic brokerage.

The markets have run up substantially over the past three months on the back of a huge inflow of FII funds.

In the paper, Sebi said FIIs and their sub-accounts should not issue or renew offshore derivative instruments in which the underlying security was a derivative.

This should be done with immediate effect.

FIIs must wind up their current positions within 18 months, and during this period Sebi will review the situation from time to time.

Further, Sebi wants to allow only those FIIs to issue more offshore derivative instruments who have issued these instruments (excluding derivatives) to a level of less than 40 per cent of their assets under custody.

However, they will issue further offshore derivative instruments at a rate of five per cent of their assets, according to the proposal.

But those FIIs, who have issued offshore derivative instruments of more than 40 per cent of their assets, can issue such instruments only if they cancel, redeem, or close their existing participatory notes.

In suggesting these measures, experts say the market regulator wants to check inflows, particularly from sources whose identity is difficult to establish.

Both the Reserve Bank of India and Sebi have, for some time now, expressed worries over participatory notes, though North Block had said on many occasions that it was not opposed to the notes.

The move comes within days of finance minister P. Chidambaram expressing surprise and concern about the surge in the markets.

“Our assessment tells us that sensex is driven by copious inflow of funds.” the minister had said.

At present, the number of FIIs and their agents issuing offshore derivative instruments has increased to 34 from 14 in March 2004.

The notional value of outstanding participatory notes has risen from Rs 31,875 crore in March 2004 to Rs 3,53,484 crore as of August this year.